How to be an ethical investor

It's a common jibe that you can be an ethical investor or a successful investor, but not both. The facts show otherwise. But there is no denying that ethical investment does restrict the choices you can make. It may prevent you from investing in booming sector, and it may make your returns more volatile.

There is no common agreement on what precisely constitutes ethical investing. For some it is simply avoiding investing in shares that are obviously pernicious: drink, tobacco, gambling, and armaments are the most commonly cited. Others adopt more exacting so- called deep green' criteria. Investors like this only invest in companies that can be said to provide positive benefits for humanity: food; water; heat and light; shelter; medical care; education and so on.

You can overlay faith-based criteria onto this pattern of investing too. Friends Provident, originally a Quaker organisation, was one of the earliest ethical investors in the UK. Methodist organisations have also been prominent ethical investors for more than a century. Islamic investing - where alcohol, gambling, armaments, pork, and companies involved in the paying and receiving of interest are avoided is another subset.

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Ethical investors also have other decisions to make. Some relate to the management organisation of the company in question. Others relate to environmental and even political concerns. Does the company conform to recognised standards of good corporate governance? Is it a major polluter? Does it invest in areas that have repressive political regimes?

Nothing here is clear-cut. The choices can be tough. What do you if your investment in a retailer (ethical) is taken over in a share for share deal with a tobacco company? What do you do if your hotel company (ethical) takes over a brewery? Is nuclear power (the cleanest and cheapest form of energy) ethical or not? Are wind turbines (which produce sustainable energy but create visual pollution and pose a threat to wildlife) ethical or not?

Professional investors have a tough time with decisions like this, and many cop out. Most fund managers subscribe, rather as they would to the virtue of motherhood and apple pie, to vague phrases like constructive engagement' or socially responsible investing'. What this really means is that they feel it's acceptable to invest in companies that may not be ethical in the strict sense of the word, as long as they are trying to improve themselves or are open to persuasion.

Another rather weak-kneed approach is for specialist funds that have to invest in specific sectors or markets to do so ethically' by drawing up a short list of preferred investments and then choosing, all other things being equal, those that are the more ethical.

Investors wanting to invest ethically should view attempts to curry favour like this with a sceptical eye. BP, for example, though it may have styled itself as beyond petroleum', still makes its profits from extracting and selling oil, thus contributing to pollution. Its relatively modest investments in alternative energy do not really alter this fact.

Pharmaceutical companies may have, under pressure from activists, dropped AIDS drugs prices in Africa but the cost of the gesture pales into insignificance beside their muscular approaches to exploiting their discoveries elsewhere and their market driven priorities that dictate more marketing put behind anti- obesity and other lifestyle drugs than finding a safe and cheap anti-malarial treatment.

An attempt to standardise criteria for ethical investing has been developed by the index provider FTSE International. It now has an ethical' index series including, for example, the FTSE 4Good UK 50. Its specific exclusions are companies involved in tobacco, parts for nuclear weapons, nuclear power, mining uranium, and armaments. Of the remaining companies theoretically capable of inclusion, they must also demonstrate that they are working towards environmental sustainability, developing positive relationships with stakeholders and upholding and supporting universal human rights.

Few would argue that these criteria are not important, but traditional areas usually proscribed by ethical investors, such as drink, and gambling, are conspicuous by their absence from the list of exclusions. In fact big oil and pharma companies, and a couple of large brewers, make the cut.

Moreover, for FTSE, areas that many would consider super-ethical such as water, waste recycling and the like, are considered high impact' from an environmental standpoint, while public transport is also considered medium impact'.

The reality is that FTSE's index is more a measure of companies confirming to environmental soundness, and stated support for equal opportunities and human rights, than a measure of what most ethical investors would consider acceptable. One can speculate on the reasons for this, but a not unreasonable assumption would be that the criteria for inclusion have had to be loosened in order for a representative sample of large companies to be capable of being included in the index.

Few would question whether BP and Shell are good companies, but whether they are suitable for strictly ethical investors is another matter. Both are in the FTSE4Good UK 50 Index. Having said that, FTSE International does claim that more than a third of the top 100 companies were excluded from the index for a variety of reasons.

Even so, private investors wanting to invest ethically should probably have no truck with indices like this, or funds based around them or tracking them, but pursue a more distinctive approach. There are two straight choices. One is simply picking stocks for yourself on personal ethical criteria: the other is to invest in a fund that does it for you.

For the most part this points one in the direction of companies that are relatively small; primarily based in the UK; where management has a significant stake in the business; where governance is good and executive pay modest; and that do something that you believe contributes positively to, or at least does not detract from human welfare. An investment in ethical stocks by and large consists of small and mid-cap growth stocks with perhaps a few ethical large caps thrown in, although establishing the true ethical credentials of large cap stocks is much more difficult.

Investing ethically via a fund is ostensibly an easier decision. This is an established subset of the fund management industry and there is plenty of choice. According to EIRIS, the ethical investment research organisation, there are now almost 90 ethical funds (defined in the broadest sense) available to UK private investors, including a number that invest ethically in overseas markets.

EIRIS figures show that in 1989 total ethical investment funds under management amounted to £199m. At the end of 2005 that figure was £6.1bn and almost certainly increased further in 2006. While part of the growth is undoubtedly due to increases in the overall level of the equity market, the growth in the number of funds, and in numbers of ethical investors, now believed to be around 500,000 in the UK alone, suggests increasing awareness of and interest in the topic.

Choosing ethical funds isn't as easy as it might seem. Adding the ethical dimension complicates the decision- making process. Choosing a normal fund requires you to balance historic performance, a view on whether the historic performance can continue, fund charges and the like. Add to this the ethical question - whether the fund conforms to your personal view of what constitutes ethical investing and the equation is more difficult to resolve. Funds vary hugely in both performance an in the ethical criteria they adopt.

Some are studiously vague; some use light green' investing (excluding the most obvious bad boys'); some use positive and negative criteria; some target environmental factors; some target ethical and environmental; some track the FTSE 4Good UK 50. With some it is hard to escape the conclusion that the ethical dimension, vaguely adhered to, is simply a marketing ploy.

The best procedure to follow here is perhaps to start with the best performers. On the whole charges tend to be high (a 5% initial charge is typical) but these are often deeply discounted by fund supermarkets.

Another good way of determining if a fund is likely to be pursuing a policy broadly in sympathy with your own ethical objectives is to look at the fund's top ten holdings. If you disapprove of the selections, don't invest.

If you want to pick stocks yourself and make sure that they are ethically acceptable, or have your existing portfolio vetted for its ethical acceptability, EIRIS offers a paid-for service for affluent private investors that will do just that.

By Peter Temple for The Daily Reckoning

Peter Temple is an investment writer, freelance analyst and former stockbroker. He has been published in the Financial Times, the Investor's Chronicle and The Zurich Club Communiqu.